Each year, billions of dollars of official and private development aid are spent on food aid, transportation infrastructure, insecticide-treated bed nets, and vaccine development for tropical diseases.1 Is this money well spent? While helping the poor is a good in itself, there is wide disagreement on how much economic growth these policies eventually will spur.
Jeffery Sachs (2005) claims that these measures will help poor nations getting their first step on the "ladder of development" and ignite self-sustaining growth. William Easterly (2006) asserts that already several trillion dollars have been spent on inefficient aid that increased corruption and that, to a large extent, failed to reach those in need.
The ultimate aim of development aid is empowering the poor so that they eventually no longer need support. Establishing how one can achieve this goal and induce long-run growth requires understanding which forces shape economic development.
Why do economies prosper? Two rival theories…
What explains the huge international differences in GDP per capita? Surprisingly, the economics profession disagrees on the answer to this fundamental question. At the risk of simplifying a diverse discussion, one can group the existing literature into two rival schools of thought emphasising either:
- geographic endowments, or
as the main determinant of economic development.
The first school of thought argues that the prevalence of disease, climate, the quality of soil, the abundance of natural resources, terrain ruggedness, and other geographic endowments directly impact income. Peasants in tropical areas are likely to be bed-ridden with malaria during harvest and have to spend much of their savings on the treatment of the disease. Agricultural yields are low in arid areas with nutrition-poor soil. While roads and railways have to be built everywhere, the cost of doing so varies greatly with the surrounding terrain. Following this line of reasoning, the "endowments" school of thought argues that most Sub-Saharan countries are among the poorest of the world due to their adverse climate, rugged terrain, and rampant disease.
The second school of thought disagrees, arguing that institutions are the basic force of development. Countries with rampant corruption and high risk of expropriation do not prosper because private effort and investment are not rewarded and, therefore, do not materialise. If checks and balances on politicians are absent, public goods are not provided efficiently or not at all. Where private contracts are not enforceable, valuable business partnerships are not formed in the first place.
An ingenious empirical literature has established the causal effect of institutions on income by utilising the fact that institutions were often superimposed by European colonisers.
For example, La Porta et al. (1998) argue that different colonisers installed very different institutions with very different associated outcomes. In an influential study, Acemoglu et al. (2001) demonstrate that differences in mortality rates of European settlers led to very different colonisation policies and institutional outcomes. In countries such as Nigeria, where the mortality rate of settlers was enormous, only a small number of Europeans arrived, and the focus of the colonisers was to exploit the local economy rather than to encourage production. In contrast, when life expectancy was high, the large influx of settlers led colonisers to install institutions that encourage production.
These authors and the other proponents of the "institutions" school of thought argue that differences in early institutional quality persist until today and that these differences can explain the large international dispersion of GDP per capita.2
… but only one correlation?
While the two rival literatures have provided ample empirical evidence for either view, the discussion is far from being settled.
A major concern is that the two literatures often interpret very similar correlations as evidence for very different theories. For example, malaria has a large effect on income today, but it also had an impact on settler mortality during colonialism. Should we attribute the high correlation between the prevalence of malaria and income to the direct effect of the disease or, rather, is it an artefact of malaria's impact on settler mortality rates and colonial institutions?
Important policy implications hinge on the answer to this question.
- If most of the effect is direct, one should distribute bed nets, mass-produce Artemisia-based medication, and develop new vaccines.
- If, on the contrary, this correlation is a by-product of the institutions brought forward by colonisation, policy should be focused on fixing past mistakes and restoring good governance.
Since the instrumental variables used in the existing institutions literature are either geographic variables themselves or are highly correlated with geography, they cannot distinguish the partial effects of geography and institutions on income. Based on similar considerations, Avinash Dixit (2007) concludes that
"the notion that geographic and historical variables are merely instruments for institutional determinants of economic success is supported more by the intuitive appeal of the stories told than by the statistical significance of the tests performed. The value of rhetoric should not be ignored, but I wish the econometric evidence were more compelling."
The interaction of history and geography can distinguish between theories of development
To address this concern, in a recent study (Auer 2008), I show how the effects of institutions and geographic endowments can be distinguished.
The key insight is that one can distinguish between the determinants of development by utilising the fact that geographic endowments had a differential effect on institutional development in former colonies and in the rest of the world. For example, in a former colony, high prevalence of malaria has reduced income because of both the direct effect of the disease on income and the indirect effect of the disease on settler mortality and thus colonisation policies. In contrast, in a country that has never been colonised, only the first of these two effects is present.
While the indirect impact of endowments on colonisation policies and thus institutions is present only in former colonies, the direct impact of endowments on income is present in all countries. Therefore, one can identify the relation between income and institutions by utilising the difference in how endowments have shaped institutional development in former colonies and in the rest of the world.
In contrast to the existing literature, this way of identifying the relation between institutions and income does not restrict the direct effect of endowments on income to be absent, thus allowing me to estimate the partial effects of the two channels.
Utilising this simple insight, I document that institutions are the main determinant of development, though not the only one. Endowments do have a statistically significant and economically relevant impact on income.
For example, in a typical specification, I find that a one standard-deviation difference in the included measures of geographic endowments is associated with a direct effect on income per capita equivalent to a seven-fold difference in GDP per capita. For a former colony, the same one standard-deviation difference is associated with an effect on colonisation policies, institutional outcomes, and thus income equivalent to an additional 18-fold difference in GDP per capita. Thus, while institutions are substantially more important that endowments, the direct effect of economic endowments can hardly be neglected.3 Together, both channels can explain around 40% of the variation in international income levels.
What is needed to end poverty?
What do these findings imply for policy?
In my view, two conclusions can be drawn.
- First, geographic endowments do matter for prosperity and we do have policy recipes at hand to address the most pressing problems of the world's poorest countries such as high prevalence of disease, lack of access to clean water, and poor agricultural yields.
Therefore, the current development efforts seem to be the only appropriate course of action and can put an end to extreme poverty. However, it is not certain that the current efforts can end poverty.
- Second, we need to be aware of the limits of the current policy recipes and need to focus much more on developing appropriate institutional reforms that can convert development aid into sustained economic growth.
While it is obvious that sick and malnourished peasants cannot easily escape poverty on their own, it is far from certain that a country with healthy and well-nourished inhabitants will automatically grow.
To ignite development, the presence of private incentives to work and invest is as fundamental as is the physical capability to do so.
What we need to know
We do understand that aligning social and private incentives is a prerequisite for growth, but unfortunately we do not understand very well how this can be achieved. As, for example, the discussion on the optimal subsidy on insecticide-treated bed nets highlights, many efficiency arguments that are taken for granted by economists may not apply in poor economies.
A major academic and policy effort should, therefore, be targeted at investigating how optimal political arrangements differ across countries at different stages of development, which is the central theme of Acemoglu et al. (2006). In this context - and although one might disagree with his controversial answers - Rodrik (2008) raises the right set of questions: what are the context-specific market and government failures that cannot be removed in the short run? What failures can be changed, and how should they be changed in this second-best world? I think that the answers to these questions are the missing pieces needed to end poverty.
Daron Acemoglu, Simon Johnson, and James A. Robinson (2001), "The Colonial Origins of Comparative Development: An Empirical Investigation," The American Economic Review, 91(5), pp. 1369-1401.
Daron Acemoglu, Philippe Aghion, and Fabrizio Zilibotti (2006), “Distance to Frontier, Selection, and Economic Growth,” Journal of the European Economic Association, 4(1), pp. 37-74.
Raphael Auer (2008), "The Colonial and Geographic Origins of Comparative Development," Swiss National Bank, Working Paper No. 2008-08.
Avinash Dixit (2007), "Evaluating Recipes for Development Success," The World Bank Research Observer, 22(2), pp. 131-158.
Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert W. Vishny (1998), "Law and Finance," The Journal of Political Economy, 106(6), pp. 1113-1155.
William Easterly (2006) The White Man's Burden: Why the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good Oxford University Press: New York
Dani Rodrik, Arvind Subramanian, and Francesco Trebbi (2004), "Institutions rule: The primacy of institutions over geography and integration in economic development", Journal of Economic Growth, 9 (2), pp. 131-165.
Dani Rodrik (2008), "Second-Best Institutions," National Bureau of Economic Research, Working Paper No. 14050.
Jeffrey Sachs (2005), The End of Poverty. Economic Possibilities for Our Time. The Penguin Press: New York.
1 The views expressed in this article do not necessarily reflect those of the Swiss National Bank.
2 It is fair to say that in the academic profession, the “institutions” school of thought is now the dominant view of development. In fact, many studies find that the direct effects of geographic endowments are minuscule once cross-country differences in institutions are taken into account, a result that has been summarised most to the point by the "Institutions Rule" verdict of Rodrik et al. (2004).
3 The finding that both channels of development matter reconciles the contrasting empirical results of the current literature. The endowments literature restricts any potential indirect effect of endowments on colonisation policies to be absent and thus overestimates the direct impact of endowments. The reverse holds true for the institutions view restricting the direct effect of endowments to be absent. Both channels matter for development and need to be accounted for in any empirical analysis.